Swedroe: Questioning Emerging Markets

With correlations dropping so much, should emerging markets still be called ‘emerging’?

According to data from the International Monetary Fund, in 1987, China was not even among the top 10 countries in terms of contribution to world GDP. Brazil (No. 8) and Russia (No. 10) were the only two emerging market countries in the top 10, and their contributions were just 2.1 and 1.7 percent, respectively.

But by 2012, China had moved to second place, with a 12.8 percent share; Brazil had moved to seventh with a 3.5 percent share; Russia was eighth with a 3.1 percent share; and India had moved into the top 10 with a 2.9 percent share. Four emerging market countries are now among the top 10 contributors to world GDP, and those four contribute more than 22 percent to the world’s GDP—virtually the same as the combined shares of Japan, Germany, France and the U.K. And the combined share of these emerging market countries is within 2 percentage points of the U.S.’ share of 24.4 percent.

So it certainly seems reasonable to expect that, in the near future, the emerging market’s share of global GDP will exceed that of the developed markets. Over the same period, the emerging market share of global market capitalization went from about 1 percent to about 13 percent.

With the dramatic globalization over the past 20 years, does it still make sense to segregate global equities into “developed” and “emerging” market buckets? That’s the question that Geert Bekaert and Campbell Harvey sought to answer in an October 2013 paper “Emerging Equity Markets in a Globalizing World.” The following is a summary of their findings:

While the correlation between developed and emerging markets has increased, the process of integration of these markets into world markets is incomplete — there’s still a large gap between the emerging markets share of global GDP and their share of global market capitalization.

Currently, emerging markets account for more than 30 percent of world GDP. However, they only account for less than 13 percent of world equity capitalization when calculated on a free float basis (shares of a public company that are freely available to the investing public). That explains part, but not all, of the gap. Based on total market cap, the emerging market share would be 20 percent.

For the full period studied, January 1988-August 2013, the MSCI World Index produced an excess return (return above the one-month Treasury bill rate) of 3.7 percent points—4.3 percentage points below the 8.0 percent excess return of the MSCI Emerging Markets. The excess return gap was even greater in the second half of the period (beginning January 2001), with the MSCI World Index producing an excess return of 2.2 percent versus the MSCI Emerging Markets’ 9.5 percent.